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Why phased annuitisation should be an option

Steve Patterson looks at how the annuitisation process can be managed for drawdown clients

Most advisers tend to think of pension drawdown as a product. But in reality, it is not. Legislation permits anyone in a regulated pension scheme to draw down their benefits as an alternative to buying an annuity.

Of course, many schemes and policies do not have the facility to accommodate drawdown and so usually, it is necessary to transfer to a plan that does. But there is no such thing as a drawdown policy per se.

The reason I highlight this is that it affects the advice process and the approach to the issue of annuitisation. It is not whether to annuitise that is the key point, but when.

For the majority of retirees on low to middle incomes, they may not be able to afford any risk to their retirement income.

But in all other cases, it is likely to be better to delay annuitisation until later in retirement, as the cost/benefit balance is far more favourable due to the higher level of mortality cross subsidy available at older ages. So, when is the right time to annuitise?

That will vary from case to case, but the period from 70 to 80 years is likely to be the most favourable. In addition, it is a mistake to think there is any one point in time that buying an annuity becomes suitable. This is a "shades of grey" ­issue instead of a black and white one.

Phased process

A phased annuitisation is likely to be far more appropriate, ­taking ­advantage of market conditions, which may be more to do with ­investment performance than ­annuity rates, although in reality it is the combination of the two that is key.

In a well-constructed drawdown portfolio, there will be a range of funds representing a variety of different asset classes. The annuity buyout yield can be measured at individual fund level rather than the plan as a whole.

This presents a range of ­buyout opportunities based on the ­performance of each different asset class, coupled with the movements in market annuity rates. By capturing gains when ­particular funds have achieved strong growth, the client will benefit from a series of annuities that lock in those gains for life in the form of a lifetime income.

Designing a suitable portfolio is a key aspect of the advice process. Ideally, this will be derived from a discounted cashflow analysis based on the anticipated profile of withdrawals. This takes into account the investor's expected income needs through retirement, and the interaction of external income sources.

This includes state pensions, ­investment and rental income, as well as other pensions including those of the partner or spouse.

By building a model of the ­client's retirement, it is possible to establish the expected yearly outgo, which particularly in the early years is vital to protect the drawdown pot against the effects of a severe drop in markets.

The combined effects of ­taking withdrawals from a fund that has dropped in value can be ­devastating on a drawdown plan, and so ­defensive asset classes such as index-linked gilts and ­overseas ­sovereign bonds are critical. These will perform positively when equities and other assets are in retreat.

The overall balance of risk must also be considered, and not simply based on the client's own attitude to risk. Other factors for consideration include the relative ­importance of the plan taking ­account of the investors' other income or capital resources, and the anticipated term of investment.

Those clients who are less d­ependent can afford more risk and younger clients can afford more risk than older investors.

The opportunity cost

The reason age is important is because drawdown, by definition, becomes progressively less suitable as the client gets older due to the ever increasing "opportunity cost" of not annuitising.

This is the other side of the ­annuity coin - as mortality subsidy is significantly higher at 75 than 65, what might have been suitable at the start of retirement will be ­considerably less so ten years later.

Just as the initial construction of the drawdown portfolio is vitally important, having clearly defined exit strategies is critical.

This demands an investment process that can be applied consistently across a firm's drawdown book, linked to client-specific ­parameters, with a view to achieving a transition over a period of years from drawdown to annuities.

Annuity drawdown arrangements can provide a useful intermediate stage in the progression. They offer continuing flexibility and the opportunity for further investment growth, while avoiding the opportunity costs of continuing annuity deferment by virtue of the fact that they also benefit from mortality cross subsidies.

They also extend the investment suitability by many years, providing a halfway house for older drawdown investors for whom conventional annuities do not meet all their needs.